Enterprise Explains: Securitized Bonds
Enterprise Explains: Securitized Bonds. With a record-breaking offering about to hit the market, securitized bonds are becoming an increasingly popular method of debt finance among real estate and consumer finance companies — private-sector and government-owned alike. Sarwa, Madinet Nasr Housing, Palm Hills, Raya and NUCA have all hopped on the securitized bondwagon (ahem) as of late, but what are securitized bonds, and how do they work?
Securitized products are backed by a portfolio of financial assets, which are pooled and repackaged as tradable securities, in this case as bonds. A wide range of assets can be securitized: residential and commercial mortgages, credit card debt, auto loans and receivables can all be packaged up and sold off to investors. The bonds are issued by a special purpose vehicle (SPV), a separate legal entity set up by the institution specifically to sell the bonds. The company sells the assets to the SPV and pockets the cash — removing the assets from its balance sheet — and the SPV then issues the bonds.
But wait, aren’t they the same thing as secured bonds? The creation of an SPV is what differentiates securitized bonds from secured bonds. The latter are guaranteed directly by the assets without the SPV as an intermediary.
So what are they good for? Securitized bonds offer quick liquidity to companies with steady future revenue streams from things like installment payments, and they allow companies to pay out interest in installments rather than as a lump sum when the bond matures. For financial institutions, enhanced liquidity means they can provide loans at a lower interest rate. For other companies, it means they can have the cash on hand while parking risk on the SPV. The SPV makes its money off the spread, the difference between the interest rate at which they purchased the assets and the interest rate on the bonds.
They’re a versatile form of investment: Because securitized bonds are issued in tranches, investors are better able to diversify, combining products with different yields, risk, and maturity in their portfolio.
And they offer investors a low-risk alternative to sovereign and corporate bonds: As they’re ultimately backed by assets, the risk of default is relatively low. The securitization process creates bonds that are “credit enhanced,” meaning their credit rating is higher than that of the underlying asset pool. Consequently, though competitive, the interest rates offered by securitized bonds will generally be lower than unsecuritized alternatives, which offer no collateral in the event everything goes bust.
The catch, though, is that in Egypt the real buyers of securitized offerings have, so far, been banks. It’s only this year that the Financial Regulatory Authority has started talking about how to make it possible for retail investors and non-bank institutional investors to get in on the action through a new type of fund.
- The IMF explains the concept of securitization here (pdf).
- Khan Academy has a solid albeit pixelated three-part explainer on mortgage-backed securities (watch, runtime: 7.56 | 9:35 | 9:18).
- The Brookings Institute explains (pdf) how mortgage-backed securities responsible for the near-collapse of the global financial system in 2007-08.
- Or were they? The University of Chicago provides the counter point.